Time to restructure midcap portfolio; 5-point model for selecting stocks

Midcaps are not bad bets at these levels. Focus on quality of assets, incomes and governance before taking the plunge.

Three interesting things happened to midcap stocks in 2018. Firstly, after rallying consistently for over 3 years, the midcaps put up a negative performance in 2018. Smallcaps did much worse. Secondly, for the first time in the last 4 years, the mid and the smallcaps are now readily available below their historical average P/E ratios of 18.52X and 16.53X, respectively.

Lastly, a lot of midcaps corrected sharply on the back of technical factors like higher margins, selling of promoter stake, increase in promoter pledges that impacted the price performances of these stocks, etc.

However, there are risks too when it comes to mid and smallcap stocks. The midcap correction started with the imposition of LTCG tax (long term capital gains tax) and the additional special margins (ASM). This made speculation in midcaps difficult and crunched volumes and liquidity.

Secondly, the last one year has revealed that many mid and smallcaps have had serious corporate governance issues. In fact, the aftermath of the IL&FS crisis and the financial market liquidity crunch have only underscored this problem.

Lastly, macros are not favouring midcap and smallcap stocks. Rupee is volatile, input costs are higher and crude oil is back on its way up. Hence, there are reasons to be cautious on some mid and smallcaps.

What should investors do at this point of time?

Clearly, it will have to be a very granular and stock-specific approach.

For example, we mentioned that midcaps are vulnerable to macros like crude oil and dollar rates. Hence, avoid midcap stocks that are import intensive or have ECBs or FCNR borrowings. These can be tricky in a strong dollar scenario.

Crude oil continues to be the big worry for midcaps for two reasons. Firstly, higher crude prices mean higher inflation. That is not great news as most midcaps and smallcaps do not have the pricing power. Secondly, crude is the input for a host of industries (predominantly midcap) and this directly impacts the operating performance and profitability of these companies. Our suggestion is to be stock specific.

While one can look at increasing their exposure to midcaps in the portfolio, the stock selection should be extremely granular and de-risked.

While there are pockets of undervaluation in midcap and smallcap stocks, there are still a lot of fundamental challenges that midcaps stocks are up against.

For example, crude prices are still elevated, the rupee is volatile and corporate governance issues still persist. Obviously, a midcap stock that has corrected over 50 percent may look optically attractive. But we have seen in the past that a sharp correction of over 50 percent in any midcap stocks does not happen without reason.

In fact, 2019 is the right time to restructure your midcap portfolio and load up in favour of quality.

Here is a 5 point model for selecting midcap stocks:

1) Avoid midcaps where the debt/equity ratio is above 3:1 and the interest coverage is below the sectoral average. Such mid caps are vulnerable to business downturns.

2) Stay away from midcaps that have strong dollar exposures either in the form of imports or dollar / FCNR borrowings. With the US growing, dollar could see sustained strengths.

3) Avoid companies that have corporate governance issues or even a semblance of corporate governance issues. Such stocks have fallen vertically in the last 1 year.

4) Be wary of midcap stocks where promoter pledge is substantial in terms of their holdings. The promoters are obviously stretched for cash and the company becomes vulnerable to equity dumping as well as to promoter dilution.

5) Lastly, don't let your mid cap exposure overall go up beyond what is prescribed in your financial plan. It may look smart to be opportunistic but in reality it may be a lot more opportunistic for you to be disciplined.

Midcaps are not bad bets at these levels. Focus on quality of assets, incomes and governance before taking the plunge. Ensure that you adopt a systematic and phased approach to these mid cap stocks. That could best protect your investment interests.

(The author is Fund Manager at Angel Broking.)

Disclaimer: The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.